A working example of effective duration calculation. Earlier we had reviewed the calculation process for Macaulay and Modified Duration. In this post we will focus on the steps for calculating Effective Duration.

Effective Duration

Effective Duration is calculated using the following formula:

Where,

Delta_i= change in yield = 1%

P0= Initial Price

P+= Price if yields increase by Delta_i

P–= Price if yields decline by Delta_i

We are calculating the effective duration of the sample instrument on the issue date. Therefore P0 is equal to the price calculated above, i.e. 98.1666.

To calculate P+ we use the same methodology for calculating the initial price but assume that the YTM has increased by 1% to 13%.

About the authorJawwad Farid

Jawwad Farid has been building and implementing risk models and back office systems since August 1998. Working with clients on four continents he helps bankers, board members and regulators take a market relevant approach to risk management. He is the author of Models at Work and Option Greeks Primer, both published by Palgrave Macmillan. Jawwad is a Fellow Society of Actuaries, (FSA, Schaumburg, IL), he holds an MBA from Columbia Business School and is a computer science graduate from (NUCES FAST). He is an adjunct faculty member at the SP Jain Global School of Management in Dubai and Singapore where he teaches Risk Management, Derivative Pricing and Entrepreneurship.